The Dilemma Facing Future Retirees
Income focused investors are in danger. The conventional wisdom is that the older one gets the more bonds one should own, because bonds are less risky. Although U.S. government bonds MAY not have default risk, today they have enormous interest rate risk. In fact, we think bonds are among the most risky asset classes. Since 1981, interest rates on 10-year U.S. Treasury bonds have fallen from 15% to 2.5%. Since bond prices move inversely with interest rates, U.S. government bonds have enjoyed a 30-plus year long bull market. So too have other bonds that price off of U.S. Treasuries, specifically municipal bonds.
Three things ultimately set the interest rate (and price) for a muni bond. 1. The rate on U.S. Treasury bonds that are a so-called "risk free" alternative. 2. The default risk of the specific state, city or municipality. In some cases, like Stockton CA and Detroit MI, this can be very high. 3. The marginal tax rate, including both federal and state, confronted by the muni investor.
While we list the tax benefit as number three, it may be the most dangerous consideration. Many investors, especially older ones, are driven to seek income as opposed to return. They overpay for tax benefits while underestimating risk of loss. One proven way to lose money is to believe that yield or income is an investment strategy or asset class. Many muni bond investors fall into this trap, thus causing them to buy things that may be unattractive and vulnerable to both inflation risk and default risk.
Yield cannot be the goal. It is merely a consequence of owning certain assets for reasons specific to the economic policies in place at any given time. The current muni bond market may be a dangerous trap. Historically, muni bonds sell at yields substantially less than Treasuries because of their tax advantaged nature. As the chart below shows, it is very anomalous for muni bonds to sell at yields higher than default free Treasuries. Muni bond buyers are in uncharted territory and will not be saved by their asset class if the policy winds turn negative for owning bonds.
There is a long tradition of thinking about this problem in the wrong way. The long history of English common law and U.S. trust law provides a conflict of interest between income and principal beneficiaries. Many trusts have been written as income to this generation and principal to the next generation. That pushes income beneficiaries to argue for higher income while the principal beneficiaries argue for future growth. This time it may be that the lower risk approach for any individual investor, especially those at or near retirement, is to avoid the low yield and high risk of bonds in favor of growth in principal type of investments, like equities.